PUBLICEXPENDITUREMANAGEMENTHANDBOOKThe World BankWashington, D.C.1998 The International Bank for Reconstructionand Development/THE WORLD BANK1818 H Street, N.W.Washington, D.C. 20433, U.S.A.All rights reservedManufactured in the United States of AmericaFirst printing June 1998This report is a study by the World Banks staff, and the judgments madeherein do not necessarily reflect the views of the Board of ExecutiveDirectors or of the governments they represent.ISBN 0-8213-4297-5iiiCONTENTSForewordPART IGUIDELINES FOR IMPROVING BUDGETARY AND FINANCIAL MANAGEMENT INTHE PUBLIC SECTORIntroduction ............................................................................................................. 1Chapter 1 DEVELOPMENTS IN BUDGET PRACTICE....................................... 11A Historical Perspective on Budget Reform ................................... 11The Way Forward.............................................................................. 16Chapter 2 INSTITUTIONAL ARRANGEMENTS FOR BETTER BUDGETARYOUTCOMES....................................................................................... 17Balancing Restraint and Flexibility.................................................. 18Operationalizing the Three Levels................................................... 26Chapter 3 LINKING POLICY, PLANNING AND BUDGETING IN AMEDIUM-TERM FRAMEWORK ......................................................... 31Weaknesses that Produce Poor Budgeting Outcomes.................... 31Linking Policy, Planning and Budgeting in the Planning andResource Management Cycle.................................................................32Linking Sector Level Policy, Planning and Budgeting................... 40Linking Policy, Planning and Budgeting at theGovernment-wide Level:A Comprehensive Medium-TermExpenditure Framework................................................................... 46Public Investment Programs (PIPs)................................................. 52Chapter 4 FINANCIAL MANAGEMENT INFORMATION SYSTEMS ................... 59FMIS Inadequacies ........................................................................... 60Institution Building and Policy Reforms.......................................... 61Developing a Core System............................................................... 61Integrating Information Systems ..................................................... 67Managing Implementation ................................................................ 70Chapter 5 APPROACHES TO BUDGET REFORM ............................................ 75Context and Issues in Budget Reform ............................................ 75Current Initiatives in Budget Reform............................................... 78Sequencing of Reform ..................................................................... 81Conclusion ........................................................................................ 90ivFIGURES2.1 Relative Importance of Different Elements of the InstitutionalFramework at each Level of Budgetary Outcome .......................... 192.2 Conceptual Framework:Authority Delegation............................... 203.1 Linking Policy, Planning and Budgeting in the Planning andResource Management Cycle .......................................................... 323.2 Public Management:Intervention and Governance ...................... 423.3 Stages of the MTEF .......................................................................... 484.1 Functional Analysis, Control Framework, and FunctionalProcesses ......................................................................................... 634.2 Information Systems Architecture for Government FiscalManagement...................................................................................... 64BOXES1 Weaknesses in Resource Allocation and Use ................................ 52 Ten Common (and Questionable) Assumptions aboutBudgeting in Developing Countries ................................................ 63 The Characteristics of Budget Systems Requiring Reform........... 74 Getting the Basics Right .................................................................. 81.1 Program Budgeting in Sri Lanka ..................................................... 141.2 Budgeting in Jamaica....................................................................... 152.1 Revenue Projections in the Philippines .......................................... 182.2 Budgetary Institutions that Promote Aggregate RestraintHelp Avoid Large Deficits................................................................. 212.3 Divergence between Budgeted and Actual Spendingin Uganda .......................................................................................... 222.4 The Negative Effect of Too Many Centralized Controlsin Ecuador......................................................................................... 232.5 IMF Code of Good Practices on Fiscal Transparency ................... 253.1 Needs versus Availability ................................................................. 333.2 Mismatch between Policy Goals and Expenditure Allocationsin Guinea ........................................................................................... 343.3 South Africas MTEF......................................................................... 343.4 Australias Mechanisms for Transparent, Competitive andResults-oriented Policy Making ....................................................... 363.5 From Journees de Reflexion to an InstitutionalizedConsultation Process ....................................................................... 373.6 New Zealands Fiscal Responsibility Act ........................................ 383.7 The First MTEF Experience in Malawi ............................................. 413.8 Sector Investment Programs (SIPs) ................................................ 443.9 An Agricultural SIP in Zambia .......................................................... 453.10 Examples of Criteria to Apply in Setting Broad ExpenditureAllocations ........................................................................................ 513.11 Dual Budgeting ................................................................................. 533.12 Concerns about PIPs........................................................................ 543.13 Shifting Emphasis in PIPs ................................................................ 56v3.14 Public Investment Programming in Latvia ...................................... 574.1 Budgeting and Accounting Reform in Transition Economies andDeveloping Countries....................................................................... 604.2 Informed Decision Making in Burkina Faso .................................... 725.1 Guidance for Strengthening Public Expenditure Management..... 795.2 New Zealand Reforms Focus on Values and Relationships .......... 805.3 Public Sector Reform in Mongolia Adopts New Zealand Model .... 825.4 Performance Indicators and Budgeting .......................................... 845.5 Towards an Outcome-oriented Budgeting System in Uganda ...... 855.6 Singapore:Milestones in Budgeting .............................................. 865.7 Client Surveys Enhance Performance Orientation ofPublic Agencies ................................................................................ 875.8 Disincentives to Sound Operational Performance ......................... 885.9 Results-oriented Public Management ............................................. 92PART IIDiagnosing the Weaknesses and Improving Budgetary and FinancialManagement in the Public Sector ............................................................................... 95CHECKLISTS OF PRACTICESLaw and Rules ............................................................................................... 96Budget Coverage and Structure................................................................... 98Budget Policy and Planning ......................................................................... 100Budget Preparation ....................................................................................... 102Budget Execution .......................................................................................... 104Aid Management ............................................................................................ 106Accounting Subsystem ................................................................................. 108Auditing System............................................................................................. 110Evaluation ...................................................................................................... 112Integrated FMIS.............................................................................................. 114Performance Measurement........................................................................... 116ANNEXESA. Diagnostic Questionnaire ................................................................... 121B. Checklist of Budget/Financial Management Practices ..................... 129C. Definition of Key Performance Measurement Terms ........................ 133D. Performance Indicators for Public Financial Management............... 137E. Education Financing in Malawi ........................................................... 145F. The Australian Experience within a Medium-Term ExpenditureFramework ........................................................................................... 155G. Data Architecture for Government Budgeting and Accounting ....... 159viH. Summary of Functional Requirements for the Budgetingand Accounting Modules of a Government FiscalManagement System ........................................................................... 163I. Budget Execution Using Information Systems.................................. 167J. IMF Code of Good Practices on Fiscal Transparency ...................... 173This handbook has evolved over the past two years. It reflects the contributions ofmanypeople.ThehandbookwascoordinatedbyMalcolmHolmes,PRMPS.Itdrawsheavily on the work of Ed Campos, Sanjay Pradhan, Ali Hashim, and Mike Stevens of theWorldBank,andBillAllanoftheIMF.OthercontributorsincludeAllenSchick,Rob Laking,andSerifSayin.ResearchsupportwasprovidedbyJ.P.SinghandShiro Gnanaselvan.JaneArmitagereviewedanearlyversionofthehandbook.Pascale Kervyn,HelgaMuller,andProfessorPhilipJoycereviewedthedraft.Vicky Mendoza,Agnes Yaptenco,andMariagraciaSchierlohprovidedtechnicalsupportandBarbaraMcGarryPeterseditedthehandbook.ThereportwasproducedbythePovertyReductionandEconomicManagement(PREM)NetworkoftheBankundertheguidance of Cheryl Gray.Comments on the handbook should be addressed to Malcolm Holmes at the WorldBank,1818H Street,Washington,D.C.20433;telephone202-473-7189,fax 202-522-7132,emailaddressmholmes@worldbank.org.Additionalmaterialonpublicexpendituremanagement,muchofitelaboratingonandupdatingmaterialinthehandbook,canbefoundontheBanksinternalpublicexpenditurewebsite.Thiswebsitewillberegularlyupdatedanditisintendedtomakeitpubliclyavailableinthenearfuture.PART IGuidelines for ImprovingBudgetary and Financial Managementin the Public SectorPART IIDiagnosing the Weaknesses and ImprovingBudgetary and Financial Managementin the Public SectorviiFOREWORDPublicexpenditureissuesareencounteredwhereverthereisadiscussionofgovernment,thepublicsector,anddevelopment.Overtheyears,theWorldBankhasinvested considerable resources in analyzing public expenditures andtheimpactsofdifferentinterventions on sustainable development.This work has both broadenedanddeepenedourunderstanding of development priorities justifying government intervention.This handbook highlights the fact that good analysis and sound policyarenotenoughtoensuresoundandsustainabledevelopmentoutcomes.AswasemphasizedintheWorldDevelopment Report 1997: The State in a Changing World, if the institutional arrangementstherulesofthegame,bothformalandinformalarenotsupportiveordemandingofgoodperformance, the results will not be sustainable on the ground.Of particular interest is the concept of three levelsofbudgetaryoutcomesaggregatefiscaldiscipline,strategicprioritization(allocativeefficiency),andoperationalperformance(technical efficiency).The need to pay attention to the interaction between these three levels,andtotheinstitutionalarrangementswithinwhichtheyareembedded,arecompellingmessages.Thishandbookprovidesabroadframeworkforthinkingaboutpublicexpendituremanagement and how it affects budgetary outcomes.In addition, useful practical insightswillrewardthediligentreader.Thoseassociatedwiththeproductionofthishandbookwouldacknowledge that this is not the final word on this subject.More empirical and theoretical workisneeded.ThereisaparticularneedtounderstandthelessonsfromreformingOECDcountries for Bank member countries.There isalsotheneedtodocumenttheexperienceofdevelopingcountriesandeconomiesintransitionifwearetohaveafullerunderstandingofwhat works and what does not.Masood AhmedVice PresidentPoverty Reduction and Economic Management1INTRODUCTIONThishandbookprovidesaframeworkforthinkingabouthowgovernmentscanattainsoundbudgetperformanceandgivesguidanceonthekeyelementsofawell-performingpublic expenditure management (PEM) system.Themultiplepurposesthatbudgetingserves-legislativecontroloftheexecutive,macroeconomic stability, allocations to strategic priorities, managerial efficiency - make budgetreformanongoingtask,apilgrimagemorethanadestination.Foranyreformagenda,thehandbookhighlightstheimportanceofthebudgetsinteractionwithothersystemsandprocessesofgovernment.Thehandbookthereforefocusesattentiononthreekeyprinciplesthatunderpinawell-performingpublicsector:clarityinwhohastheauthoritytomakewhatdecisions,thematchingofauthority(flexibility)andaccountability,andthecapacityandwillingness to reprioritize and reallocate resources.PRINCIPLES OF SOUND BUDGETING AND FINANCIAL MANAGEMENTThe approach in the handbook is shaped by principles that focus on the institution1 andare widely accepted as underpinning sound budgeting and financial management.Comprehensiveness and discipline lead thelist.Thisisbecausetheannualbudgetprocessistheonlymechanismavailable,atleastbetweenelections,todisciplinedecisionmaking.Comprehensivenessrequiresaholisticapproachtodiagnosingproblems,understandingallthelinksandevaluatinginstitutionalimpedimentstoperformanceandthenfinding the most appropriate entry point to launch phased reform that will eventually expand tobecome comprehensive.The budget must encompass all the fiscal operations of governmentandmustalsoforcepolicydecisionshavingfinancialimplicationstobemadeagainstthebackgroundofahardbudgetconstraintandincompetitionwithotherdemands.Effectiverestraintrequirescomprehensivecoverage,andchoosingthemostappropriatepolicyinstrumenttoachieveaparticularpolicyobjectivemeansthat,forsoundPEM,currentandcapitalexpendituredecisionsneedtobelinked.Discipline,coupledwitheconomy,alsoimplies that the budget should absorb only the resources necessary to implement governmentpolicies.Legitimacymeansthatdecisionmakerswhocanchangepoliciesduringimplementation must take part in and agree to the original policy decision,whetheritismadeindependentoforduringbudgetformulation.Legitimacyalsomeansthatdecisionsmadeduring the budget process should focus on those that affect policy.Associated with legitimacyis the principle that lineagenciesshoulddecidehowtomakebestuseofinputsandthatthecommunity and the private sector should make decisions that they are best placed to make.Flexibility is linked to the conceptofpushingdecisionstothepointwhereallrelevantinformationisavailable.Operationally,managersshouldhaveauthorityovermanagerial

1Institutionisusedinthishandbookinthesenseoftherulesofthegame-thehumanlydevisedandsociallysharedconstraintsthatshapehumaninteraction.Foradiscussionoftheimplicationsofthisapproach,seeIntroduction to the Guidelines for Assessing Institutional Capability by Sue Berryman.2decisionsand,programmatically,individualministersshouldbegivenmoreauthorityoverprogram decisions.This must be accompanied by transparency and accountability, but it alsorequiresatightstrategy.Tooofteninthepublicsector,implementationistightbutstrategyloose.Predictabilityisimportantforefficientandeffectiveimplementationofpoliciesandprograms.The public sector will perform better where there is stability in macroand strategicpolicy, and funding of existing policy.This requires attention to the balance between the shortterm and long term.Fiscal policymusttakeaccountoftheneedtoensurethetimelyflowoffunds to programs and projects.Thisrequiresamedium-termapproachtotheadjustmentofbudgetary imbalances, program development and evaluation.Contestabilityinpolicydevelopmentandserviceprovisionisthequidproquoforgreater predictability asitensuresthatexistingpolicyissubjecttoreviewandevaluationandthat line agency performance is subject to continuous improvement.Honestydenotesabudgetderivedfromunbiasedprojectionsofbothrevenueandexpenditure.Sources of bias can be both technical and political.Optimistic projections softenthebudgetconstraintonstrategicprioritysettingandleadtoafailuretoimplementprioritypolicies efficiently and effectively.Informationunderpinshonestyandsounddecisionmaking.Accurateandtimelyinformation on costs, outputs and outcomes is essential.Transparency and accountability require that decisions, together with their basis andtheresultsandthecosts,beaccessible,clearandcommunicatedtothewidercommunity.Transparencyalsorequiresthatdecisionmakershaveallrelevantissuesandinformationbeforethemwhentheymakedecisions.Decisionmakersmustbeheldresponsiblefortheexerciseoftheauthorityprovidedtothem.Theseareessentialasquidproquosforgreaterflexibility and also increase the demand for accurate and timely information.INSTITUTIONAL ARRANGEMENTSThehandbookcentersonimprovinginstitutionalarrangementsandmanagementpracticestocreateincentivesforbetterresourceallocation,resourceuseandfinancialmanagement.Thehandbookillustrateseffectiveinstitutionalarrangements,butdoesnotadvocateaparticularmechanism.Itdoes,however,advocatethateachcountrytrytounderstand how its particular institutional arrangements impact on budgetary outcomes.The approach has been influenced by the practice of both poorly performing and well-performinggovernmentsandbyextensiveresearchthatbuildsonthetheoryofinstitutions.Theoryandpracticeshowthatacountrysinstitutions-bothformalandinformal-haveadecisive influence on budgetary outcomes at three levels:Level 1: Aggregate fiscal disciplineLevel 2: Allocation of resources in accordance with strategic prioritiesLevel 3: Efficient and effective use of resources in the implementation of strategic priorities3The total amount of money a government spends should be closely alignedtowhatisaffordableoverthemediumtermand,inturn,withtheannualbudget;spendingshouldbeappropriatelyallocatedtomatchpolicypriorities;andthespendingshouldproduceintendedresults at least cost.Theinterdependenceofthethreelevelsisoneofthemostpowerfulfindingsofbothpractice and theory.The pursuit of aggregate fiscal discipline is often done in such a way asto undermine both level 2 and 3 performance - arbitrarily reordering prioritiesanddevastatingservicedeliveryandoperationalperformancemoregenerally.Similarly,alackofdisciplineand budgetary realism in making strategic policy choices leads to a mismatch between policiesandresources,resultingininadequatefundingforoperations.Morepositively,fiscalstabilitycreatesanenvironmentthatencouragessoundlevel2and3performance.Inturn,soundperformance at these levels feeds back into fiscal stability.World Development Report 1997: The State in a Changing World emphasizes theimportance of reinvigorating institutional capability and on balancing restraint with flexibility:State capability refers to the ability of the state to undertake collective actions atleastcosttosociety.Thisnotionofcapabilityencompassestheadministrativeor technical capacity of state officials and of supporting systems and processes,butismuchbroaderthanthat.Italsoincludesthedeeperinstitutionalmechanismsthatgivepoliticiansandcivilservantstheflexibility,rulesandrestraints to enable them to act in the collective interest.REFORMING PEMThe handbook argues that improvements in PEM require:A greater focus on performance - the results achieved with expenditure.This has the potential to engage all stakeholders in pursuit of budgetaryand financial management reform.Adequate links between policy making, planning and budgeting.This isessentialtosustainableimprovementsinalldimensionsofbudgetaryoutcomes.Well-functioning accounting and financial management systems.Theseareamongthebasicsthatunderpingovernmentalcapacitytoallocateand use resources efficiently and effectively.Attentiontothelinksbetweenbudgetingandfinancialmanagementsystems and other service-wide systems and processes of government -fordecisionmaking,fororganizinggovernment,forpersonnelmanagement.Awell-performingpublicsectorrequiresthatallcomponent parts work well and, where appropriate, together.4The handbook also provides guidance on how to recognize and deal with weaknessesin budgeting and financial management.It confronts concerns traditionally raised about donor-supported reform efforts.These include politicalcommitment,thebalancebetweensimplicityand comprehensiveness, and country implementation capacity.Politicalcommitment.Thisclearlyisimportant,butcommitmentdoesnotoccurinavacuum.Inmanyrespects,politicalwillisafunctionofthequalityoftheadviceprovidedtopoliticians and the base of support for reform.Advocates of reform have to confront the realitythatpoliticalinterestsareoftenservedbynon-transparent,non-accountablesystemsforresource allocation and use.Involving all relevant stakeholders by focusing on performance atallthreelevelsofbudgetaryoutcomes(aggregatefiscaldiscipline,prioritizationandtechnicalefficiency)isessentialtochangingtheincentivesofpoliticians.Thisalsomeansthat"bigbang" reforms are less likely to succeed: the timeframeforbudgetaryreformisnottheshortterm, but the medium to long term. Whetherdonorscontributetounderminingpoliticalwillinparticular situations also deserves attention.Simplicity/comprehensiveness.Thisrelatestokeepingitsimple.Thisisalmostcertainly true of reform efforts, but they must be based on comprehensive analysis. Itisalsotruethatreformingbudgetaryandfinancialmanagementsystemswithoutpayingattentiontotheotherservice-widesystems,processesandstructuresofgovernmentislikelytoproducelittle change.An important aspect of comprehensive analysis is an assessment of the informalrules that might stand in the way of effective reform of the formal rules.Countryimplementationcapacity.Anoftenheardrefrainistomatchreformswithimplementationcapacity.Thisisanotherformofthepleatokeepitsimple.Anoteworthydimension of this admonition is the need for donor coordination.The implementation capacityproblemisimportantlyafunctionofdonordemands.Atthesametime,theinstitutionalapproachtakeninthehandbookemphasizesexpandingcapacitybygettingtheincentivesright.As a minimum, attempting to build capacity from the supply side without addressing theincentivesembodiedintheinstitutionalframeworkwilldolittletoimproveperformance.Buildingsystemsandprocessesthatbothencourageanddemandperformancewill,inturn,unleash human and organizational capacity.WHATS WRONG WITH BUDGETINGThedecisiontopreparethishandbookcameoutofthecontinuingpoorbudgetperformance in many countries and draws strength from the improvement in budget outcomesover the past 20 years in a number of countries.Poorperformanceisoftentobefoundintheweaklinksbetweenpolicymaking,planning and budgeting (Box 1).Atonelevel,policymakingandplanningareunconstrainedby what a country will be able to afford over the medium term.At another level, policy makingandplanningareinsufficientlyinformedbytheirbudgetaryimplicationsandbytheirlikelyimpacts in the wider community.The inadequacy of hard budget restraints on decision makersattheplanningandbudgetformulationstageofthecycleleadstoinadequatefundingofoperations, poor expenditure control and unpredictability in theflowofbudgetedresourcestoagencies responsible for service delivery.5BOX 1WEAKNESSES IN RESOURCE ALLOCATION AND USEWeaknesses that undermine public sector performance include:Poor planning;No links between policy making, planning and budgeting;Poor expenditure control;Inadequate funding of operations and maintenance;Little relationship between budget as formulated and budget as executed;Inadequate accounting systems;Unreliability in the flow of budgeted funds to agencies and to lower levels of government;Poor management of external aid;Poor cash management;Inadequate reporting of financial performance; andPoorly motivated staff.Readers will be all too familiar with the link between undisciplined fiscal policy and theresulting adverse consequences on the economy and on the poor - those least able to protectthemselves.Lessoftenisthelinkmadebetweenineffectivebudgetingsystemsandunsustainedpolicychoicesandsectoralallocationsdelinkedfromstrategicpriorities.Morerarelyisthelinkmadebetweenpoorbudgetingsystemsandunsustainedpolicychoicesandsectoralallocations.Evenwherelinksaremade,theyrarelybecomearationaleforbudgetreform.Theinexorablegrowthof"investmentprojects"andpublicsectoremploymentmeansthattheannualbudgetprocessallocatesextremelylimiteddomesticresourcestokeeptoomany projects and activities alive.This places upward pressure on expenditure (manifested asarrearsinmanycountries).ThelackofcomprehensivenessinthecoverageoffiscaloperationsalsoleadstoweakPEMsystems.Thisisassociatedwithalackoftransparencyand the often well-founded assumption that there will always be some fund or donor to bail outtheindividual,theproject,theprogram,thesectororthecountry.Inturn,thissoftbudgetconstraint is reinforced bythelackoftimelyexpendituredataandaccountabilitymechanismsthat focus attention on results.AnothercharacteristicofweakPEMistheincentivetospendbudgetallocationsassoon aspossible-thereisnoguaranteethatthefundsappropriated willbeavailablelaterintheyear.PerhapsthebestindicatorofthestateofthePEMsystemistherelationshipbetweenwhatisbudgetedandwhatisactuallyspentattheprogramlevel.Ratherthanlooking for the problem in budget execution, reformers need to look at the relationship betweenpolicy making, planning and budgeting.PooraidmanagementalsosignalsaweakPEMsystem.Notsurprisingly,countriesheavilydependentonaidaremorelikelytohaveweakPEM.Majorproblemsemergefromdifferent priorities (not only between a donor and a country, but between donors) and the poorcoverage of aid funding in the budget.6Theseweaknessesarenotnewlydiscovered.In1980,Caidenwrote:"Ifevertherewasasubjectwhichhasbeenoverwritten,overanalyzedandovertheorizedwithsolittlepractical result to show for the effort, it isbudgeting in poor countries.Box 2 outlines assumptions about budgeting in developing countries, as perceived byCaiden.BOX 2TEN COMMON (AND QUESTIONABLE) ASSUMPTIONS ABOUT BUDGETING INDEVELOPING COUNTRIESThere is a common pattern of budgeting that will fit all circumstances.The aim of budgeting is economic planning.Improved budgeting depends on adequate resources.Budget decisions can be separated from policy decisions.Whatever is best coordinated is best.Comprehensive decisions are superior to partial decisions, and complex solutions are better thansimple solutions.The prerequisites of budgeting are a matter of technique and will, rather than the product ofenvironmental conditions.Politics are not as important as economics.Good budgeting is a matter of regulation.Budgeting is relevant to development.Source: Caiden, "Budgeting in Poor Countries: Ten Common Assumptions Re-examined," Public Administration Review, January/February 1980.Theevolutionofbudgetingoverthepast100yearshasinfluencedthepracticeofresourceallocationanduseinallcountries.Itiseasytosaythatdevelopingcountriesaredifferent,butallcountriesneedeffectivefiscaldiscipline,acapacitytoallocateresourcestostrategic priorities and to use resources efficiently and effectively.It is reassuring that the keyweaknesses that led to the burst ofbudgetreforminOECDcountriesoverthepast20yearsall have their parallels in developing countries and economies in transition (Box 3).Havewereallylearnedanythinginthepast20yearsthatjustifiesfurtherwriting,analyzing and, yes, even theorizing?We believetheanswerisyes,andSchick'sideaaboutGetting the Basics Right - discussed in the next section - gives us a clue as to why.What wehave needed is a much broader view of what the basics are.7BOX 3THE CHARACTERISTICS OF BUDGET SYSTEMS REQUIRING REFORMMany of the weaknesses in budgeting reflect the failure to address linkages between the variousfunctions of budgeting.The following factors contribute to budget systems and processes that create adisabling environment for performance in the public sector, both by commission and by omission:Almost exclusive focus on inputs, with performance judged largely in terms of spending no more,or less, than appropriated in the budget;Input focus takes a short-term approach to budget decision making; failure to adequately takeaccount of longer-term costs (potential and real), and biases in the choice of policy instruments(e.g., between capital and current spending and between spending, doing, and regulation) becauseof the short-term horizon;A bottom-up approach to budgeting that means that even if the ultimate stance of fiscal policy wasappropriate (and increasingly after 1973 it was not) game playing by both line and central agenciesled to high transaction costs to squeeze the bottom-up bids into the appropriate fiscal policy box;A tendency to budget in real terms, leading either to pressure on aggregate spending whereinflation is significant (which was often validated through supplementary appropriations) orarbitrary cuts during budget execution with adverse consequences at the agency level;Cabinet decision making focused on distributing the gains from fiscal drag across new spendingproposals;Cabinet and/or central agencies extensively involved in micro decision making on all aspects offunding for ongoing policy;Last minute, across-the-board cuts, including during budget execution;Weak decision making and last-minute cuts cause unpredictability of funding for existinggovernment policy; this is highlighted to the center by central budget agencies on the alert toidentify and rake back "fortuitous savings;"Strong incentives to spend everything in the budget early in the year and as quickly as possible,since the current years spending is the starting point for the annual budget haggle and the fear ofacross-the-board cuts during execution;Existing policy itself (as opposed to its funding) subject to very little scrutiny from one year to thenext. (This and previous point epitomize the worst dimension of incremental budgeting.);Poor linkages between policy and resources at the center, between the center and line agencies, andwithin line agencies because of incremental budgeting;A lack of clarity as to purpose and task and therefore poor information on the performance ofpolicies, programs and services, and their cost because of poor linkages;The linking together (in association with the point above) within government departments of policyadvising, regulation, service delivery and funding and an aversion to user charging; andOverall, few incentives to improve the performance of resources provided.8GETTING THE BASICS RIGHTIn 1997, Schick argued that the lesson for developing countries, from perhaps the mostradicalreformofthecorepublicsectoramongOECDcountries,was"GettheBasicsRight"(Box 4).In other words, reformers should focus on the basics on which reform is built, not onparticulartechniques.Thismeansthatcentralbudgetagencieshavetotaketheleadinputtinginplacethebasicstosupportallthreefunctionsofthebudget-controlofpublicresources, planning for future resource allocation and management of resources - and shouldbuildinstitutionalmechanismsthatsupportanddemandaperformanceorientationforalldimensions."Gettingthebasicsright"alsomeansthatthereshouldbeabalancebetweenrestraintandflexibilityandrecognizesthatthiswillshiftasthebasicsareembedded.Introducingmechanismstopromotetransparencyandaccountability,keyelementsoftherestraintframework,willcheckabuseofflexibilityandgeneratedemandforinformation.Aschapter5emphasizes,however,budgetreformisnotsomethingthatcanbeneatlysequenced.Reform will attract the interest of decision makers where it is directed at solving aparticular problem.Reformers must be opportunistic and use performance problems to drive ademand for getting the basics right.BOX 4GETTING THE BASICS RIGHTIn elaborating his argument for "Getting the Basics Right," Schick states:Foster anenvironmentthatsupportsanddemandsperformancebeforeintroducingperformanceor outcome budgeting.Control inputs before seeking to control outputs.Account for cash before accounting for accruals.Establish external controls before introducing internal control.Establish internal control before introducing managerial accountability.Operateareliableaccountingsystembeforeinstallinganintegratedfinancialmanagementsystem.Budget for work to be done before budgeting for results to be achieved.Enforceformalcontractsinthemarketsectorbeforeintroducingperformancecontractsinthepublic sector.Have effective financial auditing before moving to performance auditing.Adoptandimplementpredictablebudgetsbeforeinsistingthatmanagersefficientlyusetheresources entrusted to them.STRUCTURE OF THE HANDBOOKThe handbook is divided into two parts.Part I consists of five chapters.Chapter1reviewstheevolutionof100yearsofbudgetingpractice,highlightingresponses to the growing and multifaceted demands being placed on the budget.This chaptersuggeststhatapproachestobudgeting,resourceallocationandfinancialmanagementareconstantly changing to reflect which of the three functions of budgeting is in the ascendancy -controlofpublicresources,planningforthefutureallocationofresourcesormanagementof9resources.TheChapterfocusesparticularlyonthelackofsustainabilityofbudgetreformsbuiltaroundparticulartoolsortechniques.Keymessagesarethatreformeffortsusuallyfailbecausetheyareincompleteandthatpublicsectorpolicymaking,planning,budgeting,andmanagement systems and processes must be integrated.Chapter2elaboratestheinstitutionalarrangementsthataffectincentivesforbetterbudgetary outcomes, includingmechanismsthatimproveaggregatefiscaldiscipline,strategicprioritizationandoperationalefficiency.Thechapterdiscussesthepoliticalnatureofbudgeting and the need to balance restraints with flexibility.Transparencyandaccountabilityfigure importantly in this process. Transparencydemandsthatthereasonsfordecisionsandtheresultsandcostsofthesedecisionsbeaccessible,clearandcommunicatedtothewidergeneral public.Transparency also means that decision makers should have all relevant issuesbeforethemwhentheymakedecisions.Accountabilitymeansthatdecisionmakersatalllevels must be held accountable for the exercise of the authority(flexibility)providedtothem.Thechapteralsoarguesthatinformationonexpenditure,costsandresultsiscrucialtobothdecision making and effective expenditure control.The chapter ends by explaining how theseconcepts can be made operational at the three levels.Chapter3dealsinsomedepthwithlinkingpolicy,planningandbudgetingatbothasectorallevelandacrossthewholeofgovernment.Thechapterprovidesguidanceoninstitutional mechanisms that facilitate the allocation of resources over the medium term basedonstrategicobjectives.Thechapterstatesthataffordabilitymustinfluencepolicymaking,planningandbudgetingearlyinthebudgetcycleandthatadjustmentwillonlybesustainedwhereittakesplacethroughpolicychange.Amedium-termapproachthatencompassesallexpenditureprovidesalinkingframeworkandfacilitatesthemanagementofpoliciesandbudgetrealitiestoreducepressurethroughoutthewholebudgetcycle.Theresultisbettercontrolofexpenditureandbettervalueforthemoneywithinahardconstraint.Medium-termexpenditureplanningatthesectorandgovernment-widelevelsarelinked.Necessarycomponentsofthewhole-of-governmentsystemincludeinformationonthecostsofexistingpolicies and programs over the medium term, a sense of what is affordable in aggregate overthe medium term, and mechanisms tosetprioritiesinter-andintrasectorallyintheprocessofresolving the tensions between what is affordable and what is demanded.Chapter4providesguidanceonimprovingaccountingandfinancialmanagementinformation systems (FMIS), an essential part of an efficient PEM system.The chapter takes amodular approach to integrating a FMIS, starting with a core accounting system to meet basicinformationneeds.Thecorewouldcontainmodulesforaccountspayable,accountsreceivable and the general ledger.This system would support forecasting at the macro level,budget preparation and approval at the strategic level, and budget execution, core accountingandfiscalreportingattheoperationallevel.Subsidiarysystemsthatarealsoessentialtoawell-performingpublicsectoraredescribed-payment,cash,debtandcivilservicemanagementsystems,revenueadministration,andauditing.Withthecoreasafoundation,government could then expand as capacity developed to move toward a fully integrated FMIS.Chapter5explainshowcurrentapproachestoreformreflectthelessonsofpreviousexperience.This chapter argues that reform efforts fail not only because they are incomplete,but also because they are often designed to solve a technical problem when the problem liesintheinstitutionalframework.Thechaptersuggestsinstitutionalchangesthatgovernmentsmightneedtomakeintheframeworkandpointsoutthatthechangesaremostlikelytobesuccessfulwheresomeoverallvisionofawell-performingpublicsectorframesthereform10agenda.Thechapteralsosuggeststhatsequencingtakeaccountofthestateofthebasics,but that reform proceed in parallel at the center of government and at the sector/organizationallevel.Central agencies focus on reforming the policy, planning and budgeting systems so thattheyaremoresupportiveanddemandingofaperformanceorientation,whilesectorandagencylevelbodiesfocusondevelopingoutcomeandoutputinformation,supportedbycostinformation.Thekeymessageofthischapter,andofthehandbook,isthatsustainablereform,whether it be comprehensive or concerned with one component of the system, will be built byconsideringallthreelevelsofbudgetaryoutcomesandthebroaderpolitical,socialandeconomicenvironment.Thechapterconcludeswithasummaryofthecomponentsofsuccessfulreformprograms:aggregate,bindingfiscaltargets;incentivesforbetterallocationanduseofresources;autonomyoflineagencies;andaccountabilityoflinemanagers.Theconclusion also emphasizesthebroadercontextwithinwhichreformisembeddedandthatawell-performing public sector requires:a clear understanding of who has the authority to makewhatdecisions;thematchingofauthority(flexibility)andaccountability;thecapacityandwillingness to reprioritize and reallocate resources.Eachchapterhighlightsinboxesparticularconceptsofsoundresourceallocation,budgeting or financial management, drawing on country experiences wherever possible.Part IIofthehandbookcontainsdiagnosticchecklistsandquestionnairesforusebyWorldBanktaskmanagersandmembercountriestopinpointcountrystrengthsandweaknesses in budgetary and financial management practices.11CHAPTER 1DEVELOPMENTS IN BUDGET PRACTICEAn emerging consensus on the role of the budget across all countries centers on how thebudget affects:(a) macroeconomic performance; (b) allocation of resources; and c) efficiency andeffectiveness of resource use.This chapter reviews over a hundred years of budget reform, whichcontributed to the current consensus.A HISTORICAL PERSPECTIVE ON BUDGET REFORMThebroadfunctionsofbudgetingthatarecompetingforattentionare:controlofpublicresources,planningforthefutureallocationofresourcesandmanagementofresources.Therelative strength of each depends on the current view of the functionofbudgetingandbudgetingtool and techniques, but also depends on the strength of particular organizations and/or institutionalarrangements to supportthesefunctions.Throughoutmuchofthecentury,MinistriesofFinanceand Central Banks (and the IMF) have been aggressive advocates of controlofpublicresources.They have usually been supported by institutional arrangements whereby all revenues have to bepaid into a central fundandonlyaredrawnonbyauthorityofthelegislature.Thishelpsexplainwhy line item budgeting has been so enduring.Support for the other two functions has been muchmoreephemeral.AllenSchicksargumentintheIntroduction,"GettingtheBasicsRight,"i.e.,focusing on the basics on which reform is built, not on particular techniques, means encompassingall three functions aslegitimateandbuildinginstitutionalmechanismsthatsupportaperformanceorientation for all of them.Central budget agencies have to take the lead in focusing attention onthese three dimensions.Line Item Budgeting Priortothelate19thcentury,budgetinginmostcountrieswascharacterizedbyweakexecutive power, little central control and processes that were idiosyncratic.Traditional line itembudgetingisitselfareformbornofaconcernthatthelackofadequatespendingcontrolswascontributingtoanenvironmentwheretherewasincreasingdangerofsubstantialcorruption.Forthisreason,thebudgetreformersofthelate19thandearly20thcenturyadvocatedbudgetingsystemsthatwouldpromoteaccountabilityoverthedetaileduseofresources.Theearlyreformmovementfocusedontheeffectivecontrolofbudgetaccounts,establishingeconomyand,toalesser extent, efficiency as the primary values of budgeting.Inalineitemsystem,expendituresforthecomingyeararelistedaccordingtoobjectsofexpenditure, or line items.These line items are often quite detailed, specifying how much moneyaparticularagencyorsubunitwillbepermittedtospendonpersonnel,fringebenefits,travel,equipment, and the like.The most important focus of the budget system is to specify the line itemceilingsinthebudgetallocationprocessandtoensurethatagenciesdonotspendinexcessoftheirallocations.Inmanysystems,centralbudgetofficesandfinanceministriesplaytheroleofcontrollerthroughestablishingdetailedproceduresdesignedtopreventoverspending.Thestrengths of such a system lie in its relative simplicity, lack of ambiguity, and potential for control of12expendituresthrougheasycomparisonwithprioryearsandthroughthedetailedspecificationofinputs.The line item approach was not compatible with the demands accompanying the expansionof government.Budgets organized according to line items gave no information about why moneywasspent,orontheefficiencyandeffectivenessofprograms.Further,theseline-itemsystemswere almost all associated with a short time horizon, leading to failure to take longer-term costs intoaccount.Inaddition,thefocusondetailedline-itemcontrolledtomicromanagementofagencybudget implementation by central budget offices and finance ministries.Many subsequent budgetreforms have attempted to remedy these deficiencies, first by focusing on management through abudgeting approach known as performance budgeting, and later by focusing on policy and planningthroughthemoreambitiousprogrambudgeting.Morerecently,ithasbeenrecognizedthattheproblem with budget structure is not so much with line item budgeting as with excessivelytight exante control of the detail and the lack of a performance orientation in public sector institutions.Performance Budgeting This type of budgeting drew on a long-term concern with the efficiency of government andattemptedtointegrateinformationaboutgovernmentactivitiesintothebudgetprocesssothatbudget decisions could be based to a greater degree on the relationship between what governmentdid and how much it cost.The specific reform, known as "performance budgeting," was designedto allow managers to develop measures of workload and unit cost.Aperformancebudgetusuallydividesproposedexpendituresintoactivitieswithineachorganization and a set of workload measures that relate the activity performed to cost. Performancebudgeting allows the budget to be built, not incrementally (as in traditional line item budgeting), buton the basis of anticipated workload.Managers could arrive at a budget by simply multiplying thecost of a unit of output by the number of units needed in the next year.Performancebudgetingindicatedashiftfrombudgetingbasedonexpenditurecontrol,tobudgetingbasedincreasinglyonmanagementconcerns.Theemphasiswasnotonmakinggovernment-widebudgetarytrade-offs,butonmeasuringtheworkloadofanagency.Thefocuswasontheworktobedone,notontheusefulnessoftheobjectivesthemselves.Performancebudgeting was rarely adopted as a government-wide budgetary process, but is significant becauseitemphasizedtheintegrationofactivityinformationandbudgeting.Thisemphasiswastobecontinued in future reform efforts.Themajorcriticismofperformancebudgetingwasthatefficiency-animportantgoalinbudgeting - is an inadequate criterion for allocation.One of performance budgetings key strengths- linking what was to be produced with the resources required within the annual budget cycle - wasalsoaweaknessinthatitdistractedattentionfrompolicyoutcomes,whichrequireaperspectivebeyond the annual budget cycle.What was needed, according to these reformers, was a methodofbudgetingthatwouldalsotakeintoaccounttheeffectivenessofexpenditures.Theseconsiderations led to program budgeting.13Program Budgeting Beginning in the 1960s, reforms began to focus on planning for the use of public resources. The predominant early reform of this type, program budgeting, is most closely associated with theeffortstoinstituteaplanning-programming-budgetingsystem(PPBS)duringtheadministrationofU.S. President Lyndon Johnson.In this chapter, similar systems will be called program budgeting.Incontrasttoperformancebudgeting,programbudgetingwasexplicitlyfocusedonbudgetarychoicesamongcompetingpolicies.Whileperformancebudgetingwasdesignedtodiscover the most efficient method of accomplishing a given objective, program budgeting treatedthe objectives themselves as variable.Program budgeting was not a management system, but aresourceallocationsystem.Itwasaspecificalternativetothetraditionalmannerofmakingbudgeting trade-offs, which focused on marginal adjustments to the status quo.Program budgetingattempted to link program costs with the results of public programs.Keytoprogrambudgetingistheprogram-apublicpolicyobjectivealongwiththestepsnecessarytoattainit.Thebudgetisclassifiedintermsofprograms,ratherthanalongorganizational lines.Program budgeting requires that program objectives stretch beyondasinglefiscalyear.Inaddition,programbudgetingrequireseffectivenessmeasures,whichmeansthemeasurementofoutputsandoutcomes.Advocatesofprogrambudgetinghopedthatbudgetallocationdecisionswouldbemadeaccordingtothemarginalvaluethatcouldbeattainedfromvarying use of public resources.Programbudgetingistheprincipalbudgetreform(beyondtraditionallineitembudgeting)that has been exported to developing countries.In practice, program budgeting has not been verysuccessfulineitherdevelopedordevelopingcountries.Criticismsrangefromthosewhobelievethat program budgeting is so flawed in concept that it would beinapplicable in any setting, to thosewhobelievethattheprerequisitesthatwouldbenecessarytobringthereformtodevelopingcountries are currently not present.The principal argument is that it flew in the face of existing budgetary traditions and relation-ships; in particular, many people strongly objected to the suggestion that the budget process, whichis inherently political, could be made "rational."To these people, even the idea of a program (not atall self-evident) is political.Further, the effort often failed because the attempt to create programsindependent of organizational affiliation proved impossible, in light of the incentives present for civilservants to think in organizational terms.Program budgeting has had an impact where programshavebeenagencyor,atmost,sectorspecific.Inaddition,criticsarguethatitisimpossibletocompareprogramsonthebasisofeffectivenessandchooseamongthem,sincethereisnocommon index of worth for public programs.Other critics do not see program budgeting itself as a flawed concept, butrather stress theconditionsthatareneededforprogrambudgetingtobesuccessful.Thesemightinclude,forexample,adequateinformationaboutprogramsandaboutsocial,economicandenvironmentalconditions.Critics argue that these conditions are not present in many countries, thereby making itimpossible for program budgeting to take root and flourish.In addition, they argue that developingcountries often lack the trained personnel needed to carry out the requisite analyses, although this14point is usually exaggerated.More serious is the lack of stability necessary to enable longer-termbudgetary planning and the lack of consistent political commitment necessary to allow the reform tobe fully implemented.Boxes 1.1 and 1.2 present evidence for these criticisms, but particularly pointout the lack of a necessary foundation for budget reform in Sri Lanka and Jamaica. BOX 1.1PROGRAM BUDGETING IN SRI LANKASriLankaengagedinbudgetreforminearnestbeginningin1969.Thisultimatelyledtothewidespreadadoptionofasystemthatcloselyparalleledprogrambudgeting.By1974,virtuallytheentire government was presenting the budget in a program budget format.By 1975, a modest amount ofperformance data was also being presented by each of the twenty-three ministries.The program budgeting reform was spearheaded byaprogrambudgetunit,whichwasestablishedintheMinistryofFinancein1971.Thisunitissuedguidelinesonbudgetpreparation,designedtherequireddocumentation,adviseddepartmentsonthedevelopmentofperformancemeasuresandobjectives,andrevieweddepartmentperformanceagainstbudgetedtargets.Bythemid-1970s,theSriLankan budget reform seemed set to succeed.In1977,thesocialistgovernmentwasreplacedbyafree-marketfocusedgovernment.Theprogram budget unit was disbanded by the new government, deprivingprogrambudgetingoffocusandimpetus.Departmentbudgetofficescontinuedtosubmittherequiredreportsforatime,butthesanctions that had existed for failure to do so were eliminated and ministries becamemuchmorelaxintheiradherence.Further,bythe1980s,thegovernmentnolongerhadanymethodofforecastingcashflows.FollowingtherecommendationoftheIMF,eachministrywasrequiredtoreportmonthlyexpenditures,butnotinrelationtoprogramsorperformance.SriLankanbudgetingcamefullcircle;cash flow budgeting triumphed over performance monitoring.ProgrambudgetingfailedinSriLankaforthesereasons:(a)thereformhadfoundnopowerfulfriendsintheexecutiveorthelegislature;(b)therewasalackofskilledmanpowertocarryoutthereform; (c) program budgeting occurred without important parallel financial andadministrativereforms-particularlyrelatedtoaccountingandauditing-thatmighthavesustainedit;(d)thereplacementoforganizational structure with programs as the focus of decision making did not occur and, perhaps mostimportant;(e)arapid,comprehensiveandcentralizedintroductionofprogrambudgetingwasillconsideredintheSriLankanadministrativeenvironment.Amorecautiousandselectiveapproachwould have increased the likelihood that the reform could have been sustained.Source:Government Budgetingin DevelopingCountries, Chapter 6, Peter Dean.However,thedisappointmentswithprogrambudgetingarenotlimitedtodevelopingcountries.Manyoftheproblemsidentifiedindevelopingcountriescontributedtodisappointingresultsindevelopedcountriesaswell.Oneproblemisthatsuchreformscanquicklybeoverwhelmed by the information they generate.Reforms linked to program budgeting also have acentralizing tendency that overwhelms the center and can alienate line agencies.Second, tools ortechniques designed to enhance program or agency performance will only add value when they areintroducedintoapublicsectorwhereotherinstitutionalarrangementssupportaperformance15orientation.Third, the performance information generated on program outcomes will be only one ofthepiecesofinformationfeedingintoresourceallocationdecisions.Toooftentherehavebeenunrealizable expectations that the performance information will provide the answer. Even where aform of program budgeting has taken root, the links between annual budget allocations and longer-term policy outcomes are elusive.BOX 1.2BUDGETING IN JAMAICAThe Jamaica Public Administration Reform Project, approved by the World Bank Board in May of1984,containedthreecomponents:humanresourcemanagement,financialresourcemanagement,andlineagencyrestructuring.ThefinancialmanagementreformsincludedUS$600,000tohelpthegovernment convert from a line-item budget system to an output-oriented performance budget system.This portion of the project was not considered a success.This is partially the result of poor projectdesign,whichdidnotrecognizethatthesameproblemsthatexistedinthepreviousline-itemsystem(poor organization, poor planning, and lack of expenditure and revenue forecasting ability) would impaira new system as well.The fact that accounts were kept only manually andinaline-itemformatwasasignificantimpedimenttothedevelopmentofthenewsystem.Thestartingpointshouldhavebeenarevampedaccounting system, but no provision was made for this.Thereweresignificantproblemsinimplementation.Thereportsthatwerenecessaryfortheoperationofthesystemofteneitherwerenotfiledinatimelyfashion,ornotatall.Thespeedofimplementation was satisfactory, but no corrective actions were taken in response to problems identifiedintheearlyphase.Theseincludedthefactthatquantitativeperformancemeasureswereoftenaverymisleadingproxyforthetypeandqualityofgoodsandservicesprovided.Budgetpresentationnevertranslatedintobudgetimplementationnorintoaccountabilityforperformance.Lineministriesdidnothave commitment to the system, and the desire of the Ministry of Finance to hold ministries accountablefor the use of line items undermined the reform to performance accountability.Source:Project Completion Report, Jamaica:Public Administration Reform Project (Loan 2423-JM).Zero-based Budgeting (ZBB) Ina"pure"ZBBsystem,a1970serareform,insteadofconcentratingonbudgetarychangesatthemargin,allprogramsareevaluatedeachyear.Theprocessofarrivingatabudget is literally to start from scratch.At the national level, that would require answering suchquestions as, "What if we didn't have an army and navy?" or "What if Social Securitydid notexist?" In practice, no government ZBB system went this far.Many more governments haveusedavariantofZBBinwhichagencieswereaskedtoranktheirprogramswithinfundinglimits.Thequestionthusbecame,"WhatiftheMinistryofDefenseonlyreceived,e.g.,90 percentofthecurrentyear'sfunding?"Thishasnotprovedusefulasanannualbudgettool, although there have been examples where one-off use of this approach has been useful.16THE WAY FORWARDAdvocates continue to suggest that the failures of these performance-oriented tools ortechniqueshavebeeninimplementation,ratherthaninconcept.Theycontendthatthesystem could succeed with strong political backing, a program of training, gradual introductionofthesystem,andcomplementaryreformsthatwouldencourageperformance.Still,atrulysuccessfulperformancetoolortechniqueishardtofindanywhere,particularlyatthecentralgovernmentlevel.Whatcanbesaidisthatwherebudgetingsystemsandprocessesareperformance oriented it is because the institutional framework both encourages and demandsperformance.Suchaframeworkembodiesincentivesforministerstocooperateonkeystrategic decisions; for individual ministers to be given authority over program decisions and tobeheldaccountableforlivingwithintheirbudgets;andformanagerstomanage,buttheframework demands that they manage well.Thefollowingchapterswillfocusonhowallthreefunctions-controlofpublicresources, planning for future allocation of resources, and management of resources - can beaddressedsimultaneouslyandwillemphasizethekeyroleofinstitutionalmechanismsthatpromotetransparencyandaccountability.Thefocuswillcontinuetobedominatedbyexecutive government.However, since the failure of many of the reformsbasedonthetoolsandtechniquesdiscussedabovecanbelinkedtotheirfailuretoaddresstheinterestsofthefullrangeofstakeholderswhoareaffectedbytheperformanceofthebudget,institutionalmechanismstoengagethesestakeholdersarealsohighlighted.Itismanyoftheselatterfactors that provide the incentives for politicians to take performance seriously.Thefinalchapterwillarguethatinconsideringthesequencingofreform,lineitembudgetingcanbeadaptedtobeakeycomponentofabudgetsystemandprocessthatcreates strong incentives for a greater performance orientation.It is one of the basics that hastobefunctioningeffectivelybeforemoreperformance-orientedtoolsandtechniquessuchasperformanceandprogrambudgetingcanbesensiblyintroduced.Butthemessageofthishandbook is that a performance orientation is not very much about particular tools, techniquesor structures, but rather the appropriateness of a countrys institutional arrangements.17CHAPTER 2INSTITUTIONAL ARRANGEMENTS FOR BETTER BUDGETARY OUTCOMESTheexperienceofthe100yearsofreform,discussedinchapter1,andimportanttheoretical developments in the field of institutions have provided new insights into what goesinto a well-performing budget system.Oneistheacknowledgementthatthebudgethasanimpactonthreelevelsofpublicsector outcomes:1. aggregate fiscal discipline2. resource allocation and use based on strategic priorities3. efficiency and effectiveness of programs and service deliveryThesethreelevelsareareformulationofthethreefunctions-controlofpublicresources, planning for the future allocation of resources, and management of resources - thathave driven reform over the past 100 years.A second insight is that institutional arrangements - the rules of the game, both formalandinformal-influencethequalityoftheoutcomes.Underlyingtheapproachinthishandbook is the premise that resource allocation is fundamentally political and that budgetingplays a key role in disciplining decision making - from the political to the managerial.Thisinstitutionalperspectiveinnosensemeansthatthetraditionalconcernsaboutbudgetary performance are to be ignored.On the contrary, some - notably concerns about thebudgetaryinformationbase-becomeevenmoreimportant.Theinstitutionalapproachlooksat these issues through a somewhat different lens - the lens of the rules of the game.Perhapsthetendencytooverestimaterevenueinmanycountriesreflectsnotsomuchtechnicalshortcomings as the incentives operating on the system.Box 2.1 illustrates that politics lies attheheartofoverestimatingrevenue.Perhapsthefailuretoimplementadvancedintegratedfinancialmanagementinformationsystems(FMIS)isnotaresultoftechnicalandcapacityshortcomings,butrathertheinadequateincentivestodemandinformationforthepotentialusers of the outputs of the system, notably politicians and high-level public sector managers.Athirdinsightisthatthebudgetwillonlyfunctioneffectivelyonthethreelevelsifdecisionmakingandmanagementsystemsandprocessesareperformanceoriented.Budgetaryreformswillnotautomaticallyleadtobetterbudgetaryoutcomesifnonbudgetaryinstitutional arrangements are not supportive.The budget is too often seen as a process untoitself,whenitispartofabroadersetofgoverning,institutionalandmanagementarrangements.Figure2.1showsthatthebudgetprocess,systemanddirectlyrelatedinstitutionalarrangementsmaylargelyexplainlevel1outcomes.But,bythetimewegettolevel3outcomes,thebudgetisonlyoneinfluenceamongseveral,allofwhichneedtobepulling in the direction of better performance if outcomes are to improve.18BOX 2.1REVENUE PROJECTIONS IN THE PHILIPPINESInthePhilippines,overlyoptimisticrevenueprojectionshavemarkedthebudgetprocess.Politicsaccountsforasignificantpartoftheproblem.Strongpressuresareimposedonanalyststoproducesuchprojectionsfortheannualbudgetandthemedium-termexpenditureframework(MTEF).Becausepoliticiansinrealitytendtocut(notraise)taxesandstrenuouslyavoidlegislatingtaxincreases,theprojected revenue stream rarely materializes.The end result has typically been cutbacks in the allocation offunds to agencies, required by unforeseen circumstances.Two recommendations have been suggested to address these concerns:1. Technical assistance might help develop a revenue estimating model. Since the existing poor quality ofrevenue estimation is in part due to the absence of adequate data, an important first step would be to ensurethat the type of information needed for proper estimation of revenue is collected and processed. The secondstep would be to develop a more sophisticated revenue estimation capability in the Department of Finance.2. Institutional reform might also help in making revenue projections more realistic.Cabinet and othersshould restrain themselves from pushing revenue analysts to make overly optimistic forecasts.Onewaytoavoidthiswouldbetohaveanoutsidegroupofexpertsmaketheeconomicforecastswhichserveasthebasisforthebudget.Thisapproachisusedinseveralcountries(e.g.,Netherlands,whichusesforecastsmade by a committee of experts) and is accepted as an unbiased determination.Source: Penner, Rudy, et al, Capital Budgeting in the Philippines (draft), Prepared under USAID Contract # 492-0450-c-00-3091-00, 1994.BALANCING RESTRAINT AND FLEXIBILITYChapter1pointsoutthatthefocusofbudgetaryreformeffortshasoftenbeeneithertoonarrowortootechnical(andmoreoftenthannot,both).Institutionalarrangementsmustbedesignedsoastodisciplineandfacilitatedecisionmakingandthescrutinyofthosedecisionsbytheappropriateplayers,whetherthatbethePresident,ministerscollectively,individual ministers,the legislature, the community, central agencies, line agencies, individualmanagers, or front line service providers.Theseplayersoftenhavedualroles,bothascreatorsofinstitutionalarrangements(regulators)andasperformersoftasks(doers).Awell-performingpublicsectorwillhaveaclearly defined system of authority delegation.Figure 2.2 highlights the downward delegationtoagents,theupwardreportingrequirementsbyagentsandtheassociatedinstitutionalarrangements and their organizational support, which underpin a well-functioning government.The conceptual frameworkmainlyrepresentsdelegationofauthorityandcontrolmechanismsFigure 2.1RELATIVE IMPORTANCE OF DIFFERENT ELEMENTS OF THE INSTITUTIONAL FRAMEWORK AT EACH LEVEL OFBUDGETARY OUTCOMEINSTITUTIONAL ARRANGEMENTSLevel 1: AGGREGATEOutcomes FISCALDISCIPLINEBUDGETARYSYSTEM ANDPROCESSESLevel 2: RESOURCEOutcomes ALLOCATIONAND USEREFLECTSSTRATEGICPRIORITIESLevel 3: PROGRAMSOutcomes IMPLEMENTED OTHEREFFICIENTLY SYSTEMS PROCESSESAND (e.g., human resourcesEFFECTIVELY management system)20in a parliamentary system of government.There are, of course, variations of this model suchasthemorediffusedsystemofauthorityandcontrolwithinthepresidentialsystemofgovernment.In such systems, the inter-relationships are not quitesolinear,butmechanisms(checks and balances) have nevertheless been developed to balance autonomy and flexibilitywith restraint.Figure 2.2CONCEPTUAL FRAMEWORKOrganizations InstitutionsThe regulatory design and the decisions on "which player does what" reflect a concern,implicitorexplicit,forwhatisknownastheagencyproblem.Agentstowhomauthorityisdelegated face incentives that are different from those of their principals.This can contributeCabinetLegislatureMinistryDepartmentCitizenElection LawPolitical Party LawGovt. Formation LawVote of Confidence RulesBudget LawAccounting Reporting andAudit LawCabinet RulesInternalRegulationsBudgetSystemConstitution andLawsConstitutionalControlAgenciesExecutive ControlAgenciesMinistry ControlAgenciesAuthorityDelegationReportingRequirements21to outcomes at variance with those sought by principals, particularly considering the inevitableinformation asymmetries.AttheapexoftheformalregulatoryframeworkinmostcountriesistheConstitution.Below that there are many formal and informal rules that bear on budgetary outcomes.Theseinstitutional arrangements regulate the relationships among the players, through a combinationofregulationsexternalandinternaltoexecutivegovernment,simultaneouslytoimposerestraints,defineflexibilitiesandset,monitorandenforcestandards.Thelatterrequiresinformation, transparency and accountability mechanisms.Getting the right balance between restraint and flexibility is the key to better outcomesatallthreelevels.Thechallengeforeachcountryistodeterminetheappropriatebalance.Introducingmechanismstopromotetransparencyandaccountabilitykeyelementsoftherestraint frameworkwill check abuse of flexibility and generate demand for information.Restraint.Fartoooftenpolicyandplanningdecisionsareinsufficientlydisciplined(restrained)bytherealitiesofthebudgetconstraintoverthelongerterm.Theabsenceofrestraint early on in the policy, planning and budgeting cycle often results in weak expenditurecontrolfurtherdowntheline-acommonsymptomofpoorexpendituremanagement,andevident in many countries.A genuinely hard budget constraint has beenshowntobeoneofthe central features of a well-performingpublicsector(Box2.2).But,tobefullyeffective,theconstraint must be realistic, particularly in relation to sector policy demands, and it must involvea significant degree of predictability.BOX 2.2BUDGETARY INSTITUTIONS THAT PROMOTE AGGREGATE RESTRAINTHELP AVOID LARGE DEFICITSArecentstudyof20LatinAmericancountriessuggeststhatgreatertransparencyandhierarchy(i.e., systems that give considerable power over departmental spending totals to the Ministry of Finance) areassociated with lower budget deficits.The study found that countries with the least transparency and fewestaggregate spending controls ran public deficits averaging 1.8 percent of GDP, while those with the highestcombined transparency/aggregate control mechanisms ran surpluses of, on average, 1.7 percent of GDP.Source: World Development Report(based on WDR Background Paper:Alesina, Alberto, "Politics, Proceduresand Budget Deficits), 1997.Performance at all three levels of budgetary outcomes is adversely affected where theabsenceofrestraintbeginswithweakaggregatefiscaldiscipline.Atthesametime,cautionshouldbeexercisedsinceimposingoverlyrigidrestraintsatthetopmayhelptomaintaindisciplineattheaggregatelevelbutmaynotnecessarilytranslateintoimprovementsatthesectoralandorganizationallevels.Forexample,therulesofthesupranationalcentralbankhavecontributedtoaggregatefiscalrestraintinmanyoftheAfricanFrancophonecountriesaffiliatedwiththeCFAzone.Thishasledtothebuildupofarrearsinmanycountries,anditdoes not appear to have led to a greater concern for level 2 and, particularly, level 3 outcomes.22Lackofrestraintinpolicymakingandplanningmeansthatresourcesfortheannualbudgetaretoooftenalreadyovercommitted.Theconsequenceisinadequatefundingforoperationsandmaintenance.WorldBankPublicExpenditureReviews(PERs)haveshownclearly how future resourcing needs to support past and current policy, and planning decisionscannot be met.Box 3. 3 in chapter 3 illustrates remedial actions.Yet countries, often with theactive support of donors, continue to pursue an expansionary planning path.Decisions do notadequatelyconsiderfuturecostandthelikelyfutureaggregateresourceconstraint.Institutional mechanisms that symbolize and promote this situation are the dual budget systemand the traditional Public Investment Program (PIP).Mechanismstopromoteaggregatefiscalrestraintduringbudgetformulationareimportantandhelptoimproveoverallexpenditurecontrol.However,restraintduringthebudget year is also important to minimize resource reallocations during the year.This practiceisrampantinmanycountries,signalingthateithertheoriginalbudgetdidnotreflecttherealpriorities of government or that financial and/or policy discipline does not exist (Box 2.3). Eitherway,strategicprioritiesareunlikelytobeproperlyreflectedinactualexpenditure,andoperationalperformancewillbeadverselyaffected.Atthesametime,thelegitimacyofthebudget process and the credibility of budget ceilings will be undermined.BOX 2.3DIVERGENCE BETWEEN BUDGETED AND ACTUAL SPENDING IN UGANDATo increase allocations to important, yet underfunded, sectors, Uganda identified a number of PriorityProgramAreas(PPAs)intheearly1990sthatwouldreceivepriorityinresourceallocation.DonorssupportedthisapproachbylinkingfundingflowstoincreasesinbudgetallocationsforPPAs.However,reviewofactualspendingpatternsindicatedthatactualspendingwaslargelyatvariancewithbudgetedpriorities.Large amounts of supplementary expenditures were incurred by powerful ministries.The resultwasthattheaveragedeviationinactualallocationversusbudgetedallocationforPPAswasover90percent,withtherangevaryingbetween70percentfortheMinistryofEducationand590percentfortheMinistry of Justice.Source: Campos, Ed and Pradhan, Sanjay Budgetary Institutions and Expenditure Outcomes, 1996.Increasedrestraintcontributestobetterbudgetaryoutcomes,butsodoesincreasedflexibility.Theimportanttask,therefore,asSchickputitintheIntroduction,is"gettingthebasicsright,"i.e.,togettherightbalancebetweenflexibilityandrestraint.Decisionmakersandmanagersshouldhaveflexibilitytodotheirjobsandtakeactionsneededtoimproveoutcomesontheground.However,appropriaterestraintsshouldbeinplacetoensurethattheiractionsdonotleadtoindiscipline.The1997WDRidentifiesavarietyofinstitutionalmechanismsthatimposerestraintondecisionmakersandmanagersandhelpachievethisbalance.Thesemechanismsincludecompetitivepressurefrommarkets,andvoiceandparticipation from civil society.Within the state, the mechanisms include checks and balanceson theexecutiveviathelegislatureandthejudiciary.Withintheexecutive,theyincluderulesandrestraintssuchashard,butpredictable,budgetconstraints,aclearstrategywithexplicitstatement of priorities, requirements to report results, and accounting and auditing standards.23Flexibility.The importance of flexibility has been highlighted by the experience of corepublicsectorreforminanumberofOECDcountries.Attheoperationallevel,increasedmanagerialfreedom,combinedwithahard,butpredictable,budgetconstraint,hasbeenconsistentlyidentifiedasprovidingakeyincentiveforimprovedperformance.Forstrategicdecisionmaking,givingindividualministersmoreresponsibilityforresourceallocationdecisionscreatesincentivestoreprioritizeexpenditurewithinahardbudgetconstraintandincreasesaccountabilityforresults.Australianreformsofthe1980sillustratethispoint(Box 3.3 in Chapter 3).Formanydevelopingcountries,thesignsarethattoolittleflexibilityandtoomuchrestraint has often led to increasingly poor outcomes at all three levels, but particularly at levels2 and 3.The separation of policy, planning and budgeting, the subject of Chapter 3, has hadthemajornegativeconsequenceofvirtuallyeliminatingthecapacityandwillingnessofmanygovernments to reprioritize and reallocate.Box 2.4 illustrates the negative consequences thatflow from an inflexible implementation framework (level 3).BOX 2.4THE NEGATIVE EFFECT OF TOO MANY CENTRALIZED CONTROLS IN ECUADORBytheearly1990s,Ecuadorsresourceallocationandpersonneladministrationsystemswerehighlycentralizedandruleoriented.Yet,therewasgrowingrelationsthatdespitethetightinstitutionalframework,thesystemwasfailingtocontrolandlimittheuseofpubliclyheldfinancialandhumanresources.Infact,theproliferationofcontrolsactuallysowedtheseedsofitsownmalfunctioning.Thehighlycenteredbudgetsystemhadgeneratednumerousdevicesforcircumventingthenormalbudgetaryprocess, including earmarked revenues and off-budget activities.Similarly, the centralized financial controlsystem,includingbutnotlimitedtoextremelycumbersomeprocurementprocessesandarelianceonpre-controls, had led to a proliferation of autonomous entities exempt from many of those controls.The highlycentered personnel management system also failed to improve public sector outcomes.Public employment,forinstance,grewinexorablyoverthepreviousdecadeandahalfandaplethoraoflaborregimes,assupplementsandotherdevicesforcircumventingthecontrolsbuiltintothatsystememerged.Theseundermined good management and produced poor public sector outcomes.Thecountryisnowintheprocessofundoingmanyofthecenteredcontrolsandmovingtowardsamoredelegation-orientedinstitutionalframework.However,movementisslowbecauseoftheresistancethatistypicallyencounteredinmovingfromatransaction-specificcontrolregimetoamoredecentralizedone. As an example, a plan was proposed in 1995 to devolve payment controls and two years later still hadnot been implemented, largely because of central agencies fears of fiscal indiscipline.Source: Reid, Gary, "Improving Micro Budgetary Performance: The Case of Ecuador, Discussion Draft; and World Development Report, 1997.Too much flexibility, without appropriate checks andbalances,isalsoproblematicandhas led to rampant corruption in many countries.Documented causes of high corruption levelsare:distortedpolicyenvironments,alowprobabilityofbeingcaughtandpunished,andmildconsequencesifcaughtrelativetothebenefitsofcorruptpractices.Theimplicationisthatcorruptionflourisheswherepublicofficialshavealotofflexibilityanddiscretionindecision24making,butareinadequatelyrestrainedbymechanismsthatcheckarbitraryaction.Overall,this undermines state credibility and investment, and growth suffers over the long run.While too much flexibility and too little restraint engenders corruption, too little flexibilityandtoomuchrestraintbuildsrigiditiesandinhibitsinnovationandchange.Animportantstartingpointistoidentifywhichlevelofdecisionmakingisbestservedbymoreorlessflexibility and then build in transparency and accountability mechanisms to restrain flexibility.Asageneralrule,strategyshouldbetightandimplementationlooseor,toputitanotherway,keystrategicdecisionsshouldbemorecentralized,andoperationaldecisionsmore decentralized.Theweaknessinmanycountriesisloosestrategyandtightimplementation.Thecenter and the donor community may seek to make implementation tight because of the weakstrategicframework.Strategyisoftenloosebecausepolicyformulationisdispersedamongvariousgovernment(andsometimesdonor)agencies.Effectivecoordinationmechanismsatthe center of government are therefore crucial to developing a tight strategic framework.In theRepublicofGeorgia,forinstance,streamlininghasremovedoverlappingandconflictingpositionsandstrengthenedcoordination.ThefateofdraftlawsisnowdecidedinthepresenceofallmembersofthePresidentseconomiccouncilbeforesubmissiontotheparliament.Thereformshavehelpedtoenhanceconsultationandcoordination,therebyincreasing transparency in central government decision making.Transparency and AccountabilityTransparencyunderpinsaccountability,whetherthisbetransparencyintheformoftimelyandreliableexpostexternalauditsorinspecifyingexanteperformancetargets.Transparencydemandsthatthereasonsfordecisionsandtheresultsandcostsofthesedecisionsbeaccessible,clearandcommunicatedtothewidergeneralpublic.Decisionmakers must be held responsible for the exercise of the authority (flexibility) provided to them.In summary, decisions made, the basis upon which they were made, and their results and theircosts must be made available.A dimension to transparency not directly linked to accountability is also crucial to soundbudgetary outcomes.This is that decision makers should have all relevant issues before themwhen they make decisions.Thetaskistoidentifyinstitutionalarrangementsthatwillhelpgovernmentconfronttheserealworldproblemsinbuildinganeffectivepublicexpendituremanagementsystem.Transparency and accountability mechanisms lie at the center of a system that will encouragecommitment by all the players to governments formal rules on spending and the deficit and toimposecostsonpoliticiansandbureaucratsforviolations.Similarly,transparencyandaccountability are important to committing players to level 2 and 3 rules.Recently,theIMFhasdevelopedaCodeofGoodPracticesonFiscalTransparency,which is summarized in Box 2.5.The entire Code can be found in Annex J.25InformationLack of adequate information is one of the characteristics of weak budgeting systems.This usually begins with unreliable and late input information on expenditure and costs, whichiscrucialtodecisionmakingandeffectiveexpenditurecontrol.Theauditfunctionplaysanimportantroleinturninginputdataintoinformation.Auditfeaturesthatarecrucial,butoftenmissing are:internal audit, acomponentofthemanagementofexecutiveagencies;externalaudit, independent of the executive; and timely audit reports.26BOX 2.5IMF CODE OF GOOD PRACTICES ON FISCAL TRANSPARENCY1. Clarity ofRoles and ResponsibilitiesThe government sector should be clearly distinguished from the rest of the economy, and policy and management roles within government should be well defined.There should be a clear legal and administrative framework for fiscal management.2.Public Availability of InformationThe public should be provided with full information on the past, current, and projected fiscal activity of government.A public commitment should be made to the timely publication of fiscal information.3. Open Budget Preparation, Execution, and ReportingBudget documentation should specify fiscal policy objectives, the macroeconomic framework, the policy basis for the budget, and identifiable major fiscal risks.Budget estimates should be classified and presented in a way that facilitates policy analysis and promotes accountability.Procedures for the execution and monitoring of approved expenditures should be clearly specified.Fiscal reporting should be timely, comprehensive, reliable, and identify deviations from the budget.4. Independent Assurances of IntegrityThe integrity of fiscal information should be subject to public and independent scrutiny.Underpinningtheexpenditureinformationsystemisanaccountingsystem.Mostdeveloping countries have the basics of an accounting system but do not use it effectively.Inanumberofcountriesaccountingsystemsarenotwellintegratedwithplanning,budgeting,cashanddebtmanagement,andauditingsystems.Informationonnon-cashresources(assets, liabilities, people) often do not exist.Performanceinformationofeithertheoutputsofgovernmentortheoutcomesofgovernment policy is scarce.A more results-oriented public sector will require this information.Thechallengewillbetodefinetheinformationrequiredforthevariouslevelsofdecisionmaking and to avoid overloading the center.Managementinformationsystemsthatintegrateinformation on costs, expenditure, outputs, and outcomes will need to be developed.Akeypointisiftheinstitutionalarrangementsandtheincentivesembodiedinthoseframeworksaresetupright,i.e.,ifflexibilityandrestraintareappropriatelybalancedandmechanismsfortransparencyandaccountabilityareintroducedandenforced,qualityinformation will be demanded and used to improve public sector performance.27OPERATIONALIZING THE THREE LEVELSThereisnosinglebestwaytoclassifytheseinstitutionalarrangements.Toassistdiagnosis and action, it may be useful to focus on the roles and responsibilities of the variousplayers, either as regulators or doers, through the policy making, planning and budget cycle.Level 1:Aggregate Fiscal DisciplineInstitutionalarrangementsforaggregatefiscaldisciplinecanrangefromformalconstitutional restraints on aggregate expenditure (Indonesia) through formal laws (Maastricht,NewZealand,Australia)topubliccommitmentsbytheexecutive(withorwithoutthecommitmentofthelegislature-U.S.).Commitmentsofthisnaturecanusefullybesupportedby formal legal requirements that allgovernmentrevenuebepaidintoasinglefundandonlybe available for spending where there is an appropriation of funds by the legislature.All of thisshouldbesupplementedbyrestraintsimposedbyfinancialmarketsandafreepress.Formanycountries,internationalfinancialinstitutionsmayplayakeyrole,particularlyintheabsence of open financial markets.An independent Central Bank can also play an importantrole in disciplining aggregate expenditure.For example, the supranational central bank of theCFA franc zone countries imposes limits on the advances it will make to member countries to20percentofthepreviousyearstaxrevenues.Akeypointisthateachcountrywillchoosethe particular mix of institutional arrangements that will support aggregate fiscal discipline.When players have made the commitment, they are technically required to produce anestimateofwhatisaffordable,inaggregate,overthemediumterm.Thiswillrequireacapabilitytomodeltheeconomy(JacquesPolakin"TheIMFMonetaryModel-AHardyPerennial"inFinanceandDevelopment,December1997,givesevidencethatthisdoesnotrequiresophisticatedmodelingtechniques.).Thelevelofgovernmentexpenditurederivedfromthemodelcanprovidetheconstraintorcanbeusedasaguidetothesettingoftheconstraint.Determination of the estimates is not merely a technical exercise.Evidence showsthattherearecases(Box2.2)whereincentivescauseanoverestimationofrevenueinthebudget andfutureyears.Whilethisoverestimationmaynotleadtoanunderminingoffiscaldiscipline,theinevitablecutsinexpendituretoachievefiscaltargetsinvariablyhaveverydamaging effects on level 2 and 3 outcomes.TheproductionofthefiscalframeworkwillusuallybetheresponsibilityofthecentraleconomicagencieswithinputfromtheCentralBank.TheaggregateexpenditureceilingwillfeedintothedeliberationsoftheCabinetontheappropriatestanceoffiscalpolicyforthecomingbudgetyear.Theceiling,togetherwithitsrationale,shouldbepartofthebudgetcircular kicking off the annual budget cycle.The ceiling may need to be adjusted through theplanning and formulation phase to reflect new information, but the adjustmentshouldbekeptto a minimum.Whendecisionmakersformallysettheaggregateexpenditureceilingattheappropriation(legislative)stage(implicitlyorexplicitly),theymustenforcetheceiling,monitoractualexpenditureduringbudgetexecution,andidentifyasfarinadvanceaspossiblepressurepointsonaggregateexpenditure.Animportantrestraintondecisionmakersistherequirementthatactualexpenditurebereconciledwithbudgetestimatesduringbudgetexecution, and on time and publicly at the completion of the budget year.28Comprehensivenessandtransparencyareessentialforeffectiveaggregatefiscaldiscipline.Formalrulesdesignedtoachieveaggregatefiscaldisciplinecreateincentivesforevasion,particularlytotakeactivitiesoff-budgetortoengageincreativeaccounting.Extrabudgetaryfunds,earmarkingandquasi-fiscalactivitiesareamongtheegregiousexamples of ways of getting around aggregate fiscal discipline.Level 2:Resource Allocation based on Strategic PrioritiesGivenaggregatefiscaldiscipline,thesecondkeychallengeishowtoprioritizecompeting claims on scarce resources.Prioritization is fundamentally political.Politicians setprioritiesbasedontheirunderstandingofthepreferencesoftheirkeyconstituencies.Thechallenge is to structureinstitutionalarrangementstoprovidetheincentivesfortightstrategicallocation of resources and improve the quality of information needed to do this effectively.Level2isthemostdifficultto"getrightbecauseitisthemostdependentonthepolitical process.It is crucial that"politicalgovernmentprovidelegitimacytopolicydecisionsand the resource implications over the life of the policy, by being at the center of the processofreconcilingwhatisaffordableinaggregateandstrategicsectorpolicydemands.Thechoicesmadeatthislevelcanbeinformedbyinformationandanalysis,buttheyareimportantlyvaluebasedandpathdependent.Designingandsustaininginstitutionalarrangementsthatfacilitateandrequirechoicestobemadeinthepublicinterestisverydemanding.Restraints, in terms of tight strategy and affordability, are crucial here, but there isan important component of flexibility required.Characteristics of institutional arrangements that support sound strategic policy makingfollow:Acohesivepoliticalexecutivemusthaveavisionofwheretotakethecountryand must legitimize decisions made. Aforumisneededwithinwhichdecisionmakingisconstrainedbyresourceavailabilityoverthemediumtermandinwhichpolicieshavetocompetewitheachotherasideas,andforfunding.Thiswillbefacilitatedwheretherearetightlinksbetweenpolicymaking,planningandbudgeting.Theperceivedlegitimacyofthepoliciesthatemergefromthiscompetitionwillbeenhancedwherecivilsociety,theprivatesectorandthelegislatureareappropriatelyinvolved. Programmaticdecisionsforbudgetformulationmustdevolvetolineministers.Thisrequiresacapacityatthecentertoassesstheappropriatenessofthesedecisions against the overall strategic policy objectives of government and theirfinancial implications over the life of the policy.Sector expenditure ceilingswillhavetobedecideduponintheforum.Thesesectorceilingswillneedtobeconsistentwiththeaggregatefiscalconstraintand,asmuchaspossible,becompatiblewithindividualpolicydecisionsmadeintheforumduringbudgetformulation and withotherexistingpolicies.Thelatterwillrequireestimatesofthe cost of existing policies over the medium term.29 Where aid is important, there must be a cohesive and comprehensive approachtoaidmanagement.Thestrategicpolicyprioritiesofgovernmentmustbethedriver of decisions that involve aid financing. To support these institutional arrangements, there is a need for information on: - the cost of existing government policies over the medium term, - output and outcome information on each of these policies, and - cost, output and outcome information for new policy proposals. Inturn,thegenerationofreliableandtimelyinformationwillrequiresoundaccountingsystemsandrules,weIl-functioningfinancialandnonfinancialmanagementinformationsystems,andamonitoringandevaluationcapacitywithintheexecutive.Anexternalauditfunction,independentoftheexecutive,isacrucialelementoftheinstitutionalarrangementsfor checks and balances. Once the executive has formulated the budget, policy choices embodied in the budgetmust be presented to the legislature in a way that allows for effective oversight.Whatever thestructureofappropriationchosen,thelegislaturemustbeprovidedwithinformationonexpected costs, expenditure, outputs, and outcomes of individual policies. Monitoringforconsistencywithpolicyduringbudgetexecutionistheresponsibilityofindividualsectorministries.Thelegislatureandthecentercansupportthisconcernfortheimplementationofapprovedpoliciesbyrequiringanexpostreconciliationofactualandbudgeted expenditure by sector and program, and by requiring sector ministries and agenciesto report publicly on actual outcomes and outputs. The cycle begins again with this information feeding into the next budget round. Level 3:Operational Performance - Efficiency and Effectiveness Figure2.1showsthatoperationalperformanceisdependentonmanyfactors,onlysomeofwhicharedirectlylinkedtoinstitutionalarrangementsassociatedwithbudgeting.Those that can be directly linked include: thelegitimacygiventopoliciesthroughthedecisionmakingprocess,whichiscentral to their efficient and effective implementation; thepredictabilityoffundingtoapprovedpolicies-bothwithinthebudgetyearandfromoneyeartothenext(Thisisnotanargumentforprotectinggovernmentexpenditureatallcostsandinallcircumstances,butitissuggestingthatifthoseresponsibleforimplementationaretobegivenanadequateplanninghorizonthentheremustbethemaximumamountofpredictabilityinfunding.Wherechangesinfundingarerequiredbecauseofeither changing macroeconomic or sector priorities, these should be effected asfaraspossiblethroughpolicychange,asopposedtomerelyreducing-lessoften increasing - funding.);30 theincreaseddelegationtolinemanagersoftheauthoritytomakefinancialdecisionscommensuratewiththeresponsibilityforproducingoutputsandachievingoutcomes(Theexantespecificationandsubsequentreportingofoutputsandoutcomesdiscussedunderlevel2,togetherwithexternalauditingoffinancialcomplianceandperformance,providethebasisfortheaccountabilityofsectorandlinemanagers.However,theycanonlybeheldaccountablewheretheyhavetheauthoritytomakedecisionsoverthemixofinputs-bothfinancialandnonfinancial-withinahard,butpredictable,budgetconstraint.); a genuinely "hard" budget constraint - upwards and downwards - during budgetexecution. Other conditions that determine the quality of operational performance include exit andvoice opportunities (e.g., competition and client surveys), merit-based personnel practice and,moregenerally,aregulatoryenvironmentthatencouragesandrequiressoundoperationalperformance.These issues are discussed in the 1997 WDR (See also Box5.8Disincentivesto Sound Operational Performance in chapter 5). Institutionalarrangementsthathavethegreatestbearingonorganizationalperformance might be summarized as follows: resourcesandsystemssupportcommensuratewithresponsibilities(financial/human);clarity of purpose (outcomes to be achieved);clarity of task (outputs to be produced);authority (flexibility) to pursue the purpose and undertake the task;accountability for use of authority.Building on the FrameworkThe following two chapters take the above discussion of the three levels and elaboratespecific components of a well-performing budgetary system and process.Management of thethreelevelscanbeeffectivelyintegratedonlythroughaperspectivethatgoesbeyondtheannual budget cycle.Chapter 3 looks attheneedtolinkpolicy,planningandbudgetinginamedium-termexpenditureframework(MTEF)atboththewholeofgovernmentandsectorlevels.Chapter4outlinesthekeyconsiderationsinimplementingasoundfinancialmanagementinformationsystem(FMIS),thebasiccomponentthatconsistentlyunderpinsefficient PEM.PartIIofthishandbookcontainsaquestionnairetoassessthequalityofinstitutionalmechanisms(AnnexA),achecklistofpracticestoassessacountrysstageofdevelopmentandamatrixtoassessfinancialmanagement/budgetreformsandtoevaluateimprovements(Annex B).31CHAPTER 3LINKING POLICY, PLANNING AND BUDGETING IN A MEDIUM-TERM FRAMEWORKI havesooftenmaintaineditinthisHousethatIamalmostashamedtorepeatit,butunfortunatelyitisnotaprinciplewhichhasyetenteredintopublicopinion-expendituredepends on policy.Disraeli to UK House of Commons in 1862, Quoted in Heclo, 1981Thischapterdealswithlinkingpolicy,planningandbudgetingacrossthewholeofgovernmentandatasectorallevel.Thechapterprovidesguidanceoninstitutionalmechanismsthatfacilitatetheallocationofresourcestoachievestrategicobjectives. Affordability must influence policy making and planning at the point when the decision is made. Whereadjustmentisrequiredtodealwithchangingmacroeconomicconditionsand,evenmoreparticularly,changingpriorities,thatadjustmentneedstotakeplacethroughpolicychangetobesustainable.Amedium-termapproachthatencompassesallexpenditureprovides a linking framework and facilitates the management of policies and budget realities toreduce pressure throughout the whole budget cycle.The result is better control of expenditureand greater efficiency and effectiveness in implementing policies, programs and p